Misunderstanding (Totally!) Competitive Currency Devaluations

Before becoming Governor of the Resesrve Bank of India, Raghuram Rajan professor was Professor of Finance at the University of Chicago Business School. Winner of the Fischer Black Prize in 2003, he is the author numerous articles in leading academic journals in economics and finance, and co-author (with Luigi Zingales) of a well-regarded book Saving Capitalism from the Capitalists that had some valuable insights about financial-market dysfunction. He is obviously no slouch.

Unfortunately, based on recent reports, Goverenor Rajan is, despite his impressive resume and academic credentials, as Marcus Nunes pointed out on his blog, totally clueless about the role of monetary policy and the art of central banking in combating depressions. Here is the evidence provided by none other than the Wall Street Journal, a newspaper whose editorial page espouses roughly the same view as Rajan, summarizing Rajan’s remarks.

Reserve Bank of India Governor Raghuram Rajan warned Wednesday that the global economy bears an increasing resemblance to its condition in the 1930s, with advanced economies trying to pull out of the Great Recession at each other’s expense.

The difference: competitive monetary policy easing has now taken the place of competitive currency devaluations as the favored tool for playing a zero-sum game that is bound to end in disaster. Now, as then, “demand shifting” has taken the place of “demand creation,” the Indian policymaker said.

A clear symptom of the major imbalances crippling the world’s financial market is the over valuation of the euro, Mr. Rajan said.

The euro-zone economy faces problems similar to those faced by developing economies, with the European Central Bank’s “very, very accommodative stance” having a reduced impact due to the ultra-loose monetary policies being pursued by other central banks, including the Federal Reserve, the Bank of Japan and the Bank of England.

The notion that competitive currency devaluations in the Great Depression were a zero-sum game is fallacy, an influential fallacy to be sure, but a fallacy nonetheless. And because it is – and was — so influential, it is a highly dangerous fallacy. There is indeed a similarity between the current situation and the 1930s, but the similarity is not that monetary ease is a zero-sum game that merely “shifts,” but does not “create,” demand; the similarity is that the fallacious notion that monetary ease does not create demand is still so prevalent.

The classic refutation of the fallacy that monetary ease only shifts, but does not create, demand was provided on numerous occasions by R. G. Hawtrey. Almost two and a half years ago, I quoted a particularly cogent passage from Hawtrey’s Trade Depression and the Way Out (2nd edition, 1933) in which he addressed the demand-shift fallacy. Hawtrey refuted the fallacy in responding to those who were arguing that Britain’s abandonment of the gold standard in September 1931 had failed to stimulate the British economy, and had damaged the world economy, because prices continued falling after Britain left the gold standard. Hawtrey first discussed the reasons for the drop in the world price level after Britain gave up the gold standard.

When Great Britain left the gold standard, deflationary measures were everywhere resorted to. Not only did the Bank of England raise its rate, but the tremendous withdrawals of gold from the United States involved an increase of rediscounts and a rise of rates there, and the gold that reached Europe was immobilized or hoarded. . . .

In other words, Britain’s departure from the gold standard led to speculation that the US would follow Britain off the gold standard, implying an increase in the demand to hoard gold before the anticipated increase in its dollar price. That is a typical reaction under the gold standard when the probability of a devaluation is perceived to have risen. By leaving gold, Britain increased the perceived probability that other countries, and especially the US, would also leave the gold standard.

The consequence was that the fall in the price level continued [because an increase in the demand to hold gold (for any reason including speculation on a future increase in the nominal price of gold) must raise the current value of gold relative to all other commodities which means that the price of other commodities in terms of gold must fall — DG]. The British price level rose in the first few weeks after the suspension of the gold standard [because the value of the pound was falling relative to gold, implying that prices in terms of pounds rose immediately after Britain left gold — DG], but then accompanied the gold price level in its downward trend [because after the initial fall in the value of the pound relative to gold, the pound stabilized while the real value of gold continued to rise — DG]. This fall of prices calls for no other explanation than the deflationary measures which had been imposed [alarmed at the rapid fall in the value of gold, the Bank of England raised interest rates to prevent further depreciation in sterling — DG]. Indeed what does demand explanation is the moderation of the fall, which was on the whole not so steep after September 1931 as before.

Yet when the commercial and financial world saw that gold prices were falling rather than sterling prices rising, they evolved the purely empirical conclusion that a depreciation of the pound had no effect in raising the price level, but that it caused the price level in terms of gold and of those currencies in relation to which the pound depreciated to fall.

Here Hawtrey identified precisely the demand-shift fallacy evidently now subscribed to by Governor Rajan. In other words, when Britain left the gold standard, Britain did nothing to raise the international level of prices, which, under the gold standard, is the level of prices measured in terms of gold. Britain may have achieved a slight increase in its own domestic price level, but only by imposing a corresponding reduction in the price level measured in terms of gold. Let’s see how Hawtrey demolishes the fallacy.

For any such conclusion there was no foundation. Whenever the gold price level tended to fall, the tendency would make itself felt in a fall in the pound concurrently with the fall in commodities. [Hawtrey is saying that if the gold price level fell, while the sterling price level remained constant, the value of sterling would also fall in terms of gold. — DG] But it would be quite unwarrantable to infer that the fall in the pound was the cause of the fall in commodities.

On the other hand, there is no doubt that the depreciation of any currency, by reducing the cost of manufacture in the country concerned in terms of gold, tends to lower the gold prices of manufactured goods. . . . [In other words, the cost of production of manufactured goods, which include both raw materials – raw materials often being imported — and capital equipment and labor, which generally are not mobile, is unlikely to rise as much in percentage terms as the percentage depreciation in the currency. — DG]

But that is quite a different thing from lowering the price level. For the fall in manufacturing costs results in a greater demand for manufactured goods, and therefore the derivative demand for primary products is increased. [That is to say, if manufactured products become relatively cheaper as the currency depreciates, the real quantity of manufactured goods demanded will increase, and the real quantity of inputs used to produce the increased quantity of manufactured goods must also increase. — DG] While the prices of finished goods fall, the prices of primary products rise. Whether the price level as a whole would rise or fall it is not possible to say a priori, but the tendency is toward correcting the disparity between the price levels of finished products and primary products. That is a step towards equilibrium. And there is on the whole an increase of productive activity. The competition of the country which depreciates its currency will result in some reduction of output from the manufacturing industry of other countries. But this reduction will be less than the increase in the country’s output, for if there were no net increase in the world’s output there would be no fall of prices. [Thus, even though there is some demand shifting toward the country that depreciates its currency because its products become relatively cheaper than the products of non-depreciating currencies, the cost reduction favoring the output of the country with a depreciating currency could not cause an overall reduction in prices elsewhere if total output had not increased. — DG]

Hawtrey then articulates the policy implication of the demand-shift fallacy.

In consequence of the competitive advantage gained by a country’s manufacturers from a depreciation of its currency, any such depreciation is only too likely to meet with recriminations and even retaliation from its competitors. . . . Fears are even expressed that if one country starts depreciation, and others follow suit, there may result “a competitive depreciation” to which no end can be seen.

This competitive depreciation is an entirely imaginary danger. The benefit that a country derives from the depreciation of its currency is in the rise of its price level relative to its wage level, and does not depend on its competitive advantage. [There is a slight ambiguity here, because Hawtrey admitted above that there is a demand shift. But there is also an increase in demand, and it is the increase in demand, associated with a rise of its price level relative to its wage level, which does not depend on a competitive advantage associated with a demand shift. — DG] If other countries depreciate their currencies, its competitive advantage is destroyed, but the advantage of the price level remains both to it and to them. They in turn may carry the depreciation further, and gain a competitive advantage. But this race in depreciation reaches a natural limit when the fall in wages and in the prices of manufactured goods in terms of gold has gone so far in all the countries concerned as to regain the normal relation with the prices of primary products. When that occurs, the depression is over, and industry is everywhere remunerative and fully employed. Any countries that lag behind in the race will suffer from unemployment in their manufacturing industry. But the remedy lies in their own hands; all they have to do is to depreciate their currencies to the extent necessary to make the price level remunerative to their industry. Their tardiness does not benefit their competitors, once these latter are employed up to capacity. Indeed, if the countries that hang back are an important part of the world’s economic system, the result must be to leave the disparity of price levels partly uncorrected, with undesirable consequences to everybody. . . .

The picture of an endless competition in currency depreciation is completely misleading. The race of depreciation is towards a definite goal; it is a competitive return to equilibrium. The situation is like that of a fishing fleet threatened with a storm; no harm is done if their return to a harbor of refuge is “competitive.” Let them race; the sooner they get there the better. (pp. 154-57)

Hawtrey’s analysis of competitive depreciation can be further elucidated by reconsidering it in the light of Max Corden’s classic analysis of exchange-rate protection, which I have discussed several times on this blog (here, here, and here). Corden provided a deep analysis of the conditions under which exchange-rate depreciation confers a competitive advantage. For internationally traded commodities, it is hard to see how any advantage can be derived from currency manipulation. A change in the exchange rate would be rapidly offset by corresponding changes in the prices of the relevant products. However, factors of production like labor, land, and capital equipment, tend to be immobile so their prices in the local currency don’t necessarily adjust immediately to changes in exchange rate of the local currency. Hawtrey was clearly assuming that labor and capital are not tradable so that international arbitrage does not induce immediate adjusments in their prices. Also, Hawtrey’s analysis begins from a state of disequilibrirum, while Corden’s starts from equilibrium, a very important difference.

However, even if prices of non-tradable commodities and factors of production don’t immediately adjust to exchange-rate changes, there is another mechanism operating to eliminate any competitive advantage, which is that the inflow of foreign-exchange reserves into a country with an undervalued currency (and, thus, a competitive advantage) will normally induce monetary expansion in that country, thereby raising the prices of non-tradables and factors of production. What Corden showed was that a central bank willing to tolerate a sufficiently large expansion in its foreign-reserve holdings could keep its currency undervalued, thereby maintaining a competitive advantage for its country in world markets.

But the corollary to Corden’s analysis is that to gain competitive advantage from currency depreciation requires the central bank to maintain monetary stringency (a chronic excess demand for money thus requiring a corresponding export surplus) and a continuing accumulation of foreign exchange reserves. If central banks are pursuing competitive monetary easing, which Governor Rajan likens to competitive exchange-rate depreciation aimed at shifting, not expanding, total demand, he is obviously getting worked up over nothing, because Corden demonstrated 30 years ago that a necessary condition for competitive exchange-rate depreciation is monetary tightness, not monetary ease.

Sir: What are the redistributive implications of monetary ease? Even if it’s true, as you say, that monetary ease is not a zero sum game, how far does that get us? A lot of people may still be worse off afterwards. I’d like to know who those people are, and whether they are the poor and most vulnerable, which I suspect they would be. Perhaps, if you represented a country as poor as India, you’d be more inclined to agree with the target of your ire.

“The difference: competitive monetary policy easing has now taken the place of competitive currency devaluations as the favored tool for playing a zero-sum game that is bound to end in disaster. Now, as then, demand shifting has taken the place of demand creation, the Indian policymaker said.”

Would it be fair to say that devaluation / monetary policy easing taken to the extreme by more than one country leaves both countries worse off? Picture two countries – Zimbabwe Major and Zimbabwe Minor both hyperinflating. Relative differences aside, is either country better off than prior to hyperinflation?

Lars, Thanks, Lars, but why do you find it incredible that he would say such things? He has lots of company.

maynardGkeynes, One cannot infer the distributional effects of monetary ease without a theory of how monetary ease affects the overall economy. Opponents of monetary ease make a variety of arguments against monetary ease. I find the reasoning underlying their arguments against monetary ease to range from dubious incoherent. My opinion is, WADR, that their distributional arguments are simply pretextual to divert attention from the weakness of the macroeconomic analysis. Now I am prepared to give you the benefit of the doubt and grant that you are sincerely concerned about the effect of monetary ease on the poor, but that still doesn’t detract from the fact that the most important and effective antipoverty program is to increase employment.

Frank, In general I don’t care for medical analogies to macroeconomic policy, but if we compare monetary easing to administering medication to a patient, there is obviously an issue about what dosage to administer. Just because you can kill a patient by overmedication doesn’t prove that there is not an optimum dose that would help restore the patient’s health. Hyperinflation is an overdose of a potentially beneficial medication.

Luis, I’ll let the BIS and RBOI fight it for him.

Digital Cosmology, I have just shown that his reasoning is incoherent. How can he be right? Only in the way that a broken 12-hour clock is right twice a day.

“What Corden showed was that a central bank willing to tolerate a sufficiently large expansion in its foreign-reserve holdings could keep its currency undervalued, thereby maintaining a competitive advantage for its country in world markets.”

Not necessarily true. The advantage can come in the form of foreign investment as the local currency becomes cheaper.

Then you wrote:

“Corden demonstrated 30 years ago that a necessary condition for competitive exchange-rate depreciation is monetary tightness, not monetary ease.”

But 30 years ago the world was very different. US had a trade deficit with China of about 1 billiona year, most of Europe was under control by the Soviet Union and the Euro did not exist as well as all the free trade agreements. After all these, do you still think that the conclusion is “necessary”?

Regardless, I understand that Dr. Rajan spoke of monetary ease taking the place of the traditional currency devaluations. The corollary does not change or invalidate his point. However, his point is half true because China is involved in currency depreciation strategies. Given that the economies of US and China are now inextricably related, it appears that 30-year old arguments have to be revised. There is an apparent effort to keep the trade from China coming while shifting demand from the rest of the world to China. The beneficiary of all this is China and the US because the trade deficit returns in the form of bond purchases that help maintain a low long-term interest rate. The losers are economies that have mistakenly entered a currency union like the EU, where the strong currency, the Euro, facilitates a shift of demand from Europe to China and the US. Actually, this was the main reason for the PIIGS collapse. They lost textile industry and then they lost electronics and durable goods industry. It all went to China and it was due to the very strong Euro which justified important more than local production. But all those were political decisions.

David, you cannot separate economics from politics and specifically geopolitics. Economics is a humble and obedient servant of politicians’ agendas and cannot stand on its own because it also involves an anticipatory component, according to which, what is decided today depends on future (desired) conditions. Since this model is will have frequent failures, economics frequently fails and people wonder whether it is science or not. Well, economics is a decision process that has no fixed rules and it is science only to that extent. Both you and Dr. Rajan can be correct at different times for different reasons. Empirically, it appears that Dr. Rajan is correct now.

Excellent blogging. By the way, how is it the European Central Bank has a “very very accommodative” stance that is leading to deflation?
If ever again we see inflation of, say, 4 percent in Europe, what ssuperlatives will be dragged out to describe the European Central Bank?

David: Monetary easing works, if at all, by reducing real wages, which are are sticky downward, by means of higher inflation. (You reject Friedman, IIRC.) Arguing that reducing wages helps the poor and working class is absurd, yet it is something that both you and Prof. Summers think is just great, apparently. How about if all of the economists at the FTC agree to reduce their wages by 10%, so that the FTC can hire 1 (approx) unemployed economist for every 10 of you holding jobs now. Is this “reduction of the unemployment rate ” your idea of a “healthy” economy?

“Frank, In general I don’t care for medical analogies to macroeconomic policy, but if we compare monetary easing to administering medication to a patient, there is obviously an issue about what dosage to administer. Just because you can kill a patient by overmedication doesn’t prove that there is not an optimum dose that would help restore the patient’s health.”

I agree that medical analogies don’t work very well for macroeconomic policy. However, continuing the analogy, what typically happens with medication is that the patient builds a tolerance over time to the medication so that it takes ever increasing dosages to achieve the same effect. Meaning, there is no optimum medication because the medication does not cure the underlying disease.

If over reliance on debt fueled consumption is the disease, then cheaper credit is not going to cure it.

About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.